muni bonds - All posts tagged muni bonds

The muni market hasn’t posted much reaction to Puerto Rico’s mammoth bankruptcy filing this week. The iShares S&P National AMT-Free Municipal Bond Fund (MUB) stayed right around $109, roughly where it has been for the past three months.

But that doesn’t mean muni investors should be shrugging off the largest bankruptcy filing in U.S. history.

Municipal Market Analytics’ Matt Fabian puts it in pretty start terms in his Default Trends report Friday. Here’s his summary of his report:

Assuming all remaining Puerto Rico bonds end up in payment default, as now appears likely, the municipal market’s total for bonds in default will have roughly doubled to $74B, with Puerto Rico issuers accounting for 85% of that total. This would also roughly double the municipal market’s current default rate from 1.02% to 1.93% (versus 0.30% excluding Puerto Rico bonds). This is a dramatic reshaping of the industry’s overall risk profile and will doubtless drive at least somewhat more conservative investor behavior in the future, in particular as regards large distressed governments like IL, NJ, CT, KY, and Chicagoland credits.

BlackRock‘s municipal-bond team of Peter Hayes, James Schwartz, and Sean Carney today points out that the muni market had a “perfectly positive” year in 2014, posting a net gain in each of the years’ 12 calendar months, while muni mutual funds were nearly perfect on a weekly basis, posting net inflows in 50 out of 52 weeks. For 2015, BlackRock says investors should adopt a barbell strategy focusing on short-dated bonds maturing in two years or less and long-dated bonds maturing in 15 to 20 years. From BlackRock:

Ratios remain attractive (at year-end, 30-year munis were outyielding 30-year Treasuries before tax, making their yields even more attractive after tax). Munis are built for income, and investor appetite for income is insatiable. To wit, demand remains very strong and we foresee another year of net negative supply—a scenario that is good for pricing. Our strategy heading into 2015 is to maintain a barbell approach, holding very short maturities for liquidity and longer maturities for yield pick-up and to benefit from a flattening yield curve. We see greatest value in lower-rated investment-grade securities. Overall, munis are a momentum-driven market. With 2014 momentum well intact, we see little reason for big changes as the calendar turns the page.

Sector-wise, BlackRock likes state tax-backed and essential-service bonds, particularly in Texas, Virginia and the Plains States, as well as school-district bonds and dedicated-tax bonds. BlackRock is underweight land-secured bonds, senior-living bonds and pre-refunded bonds, as well as Puerto Rico bonds.

Energy companies are getting clobbered left and right as the price of oil continues to plunge, hurting corporate bond investments along the way, but one type of bond is flourishing: toll-road bonds. This subsector of the municipal bond market is benefiting as more drivers take to the road thanks to cheaper gas. Brian Chappatta and Elizabeth Campbell report for Bloomberg today:

Debt backed by toll and turnpike revenue has earned 12.1 percent this year, compared with 9.5 percent for all munis, Bank of America Merrill Lynch data show. The outperformance is the most since the data began in 2005 as investors bet that Americans will drive more as the price of oil plunges to the lowest level since 2009.

About 46.3 million people in the U.S. were set to travel more than 49 miles (79 kilometers) during the Thanksgiving holiday period, the most since 2007, according to a projection from AAA. The trend signals a buying opportunity in toll bonds, which offer above-average yields as municipal interest rates remain close to generational lows, according to American Century Investments and Morgan Stanley.

The story says toll-road traffic is expected to grow as much as two percent next year, and quotes Morgan Stanley muni researcher Michael Zezas recommending muni investors allocate more cash to tollway and airport debt next year. More from the Bloomberg story:

Municipal issuers have $118 billion of debt tied to toll roads, bridges and tunnels, data compiled by Bloomberg show. The biggest borrowers are the New Jersey State Turnpike Authority, the Bay Area Toll Authority, which runs the San Francisco-Oakland Bay Bridge, and the North Texas Tollway Authority.

So-called “green bonds” are proliferating, helping municipal issuers reach new buyers while ostensibly promoting environmentally friendly projects. But do they make economic sense for their issuers? Bank of America Merrill Lynch‘s muni team of Philip Fischer, Yingchen Li, and Celena Chan is out with a report examining that question. BofA says this market has grown to $1.6 billion since its June 2013 debut, and explains exactly what a green bond is:

While still a nascent market, the applicability and suitability of green bond issuance for municipal issuers is endless. To be sure, most market participants and commentators believe that municipal bonds are largely already “green bonds” naturally.

Green bonds are bonds whose proceeds are specifically earmarked for projects and activities that promote climate and other environmental sustainability purposes. The use of bond proceeds is the only essential factor differentiating a green bond from a non-green bond. That is, the security for the bond, if a green general obligation bond, is still the full faith, credit and taxing power of the issuer. If the bond is a green revenue bond, the pledge remains the gross or net revenues of the “green” project.

BofA says green bonds are self-labeled by the issuer without any legally binding guidelines. Instead they’re governed by a voluntary set of recommendations under the Green Bond Principles (GBP), which establish four qualifying types of green bond and seven broad categories of qualifying projects: renewable energy, energy efficiency, sustainable waste management, sustainable land use, biodiversity conservation, clean transportation, and clean water and/or drinking water. BofA says all those project types “fall squarely under the auspices of municipal finance,” and that a nation generally in urgent need of infrastructure improvement can ensure it’s done in eco-friendly ways.

BofA cites a recent proposal from the New York City comptroller saying green bonds let the city tap “into the growing pool of ‘double bottom line’ institutional and individual investors – investors who not only seek quality returns, but who also want to invest in particular types of environmentally-friendly projects.” This could grow the market beyond investors whose primary concern is tax exemption.

BofA then asks whether green bonds make economic sense yet:

Will labeling an issue “green” provide an issuer with a tangible economic benefit that it would not have otherwise received if it did not label it so? The answer is maybe, but also maybe not…. [I]ssuers have little current incentive to label an issue green because, naturally, most of their issues are already green. The costs of green certification, and those for maintaining that certification, may outweigh the benefits issuers are currently experiencing. We compared selected green bonds from Massachusetts and California to their comparable non-green state general obligation bonds and found that the [spreads] of these bonds are very similar to one another, and that there is no apparent significant advantage or disadvantage to being “green”. With that said, if mutual funds were to offer diversified, certified green bond funds, the demand and therefore the borrowing cost benefits would increase.

Muni bonds have had a great year, so there haven’t really been too many opportunities to bargain-shop lately. But that could change in the next few weeks, according to Morgan Stanley Wealth Management. A combination of heavy expected issuance of new muni bonds this month and year-end positioning by financial institutions could cause supply to temporarily overwhelm demand.

Should institutions step back early due to year-end maneuvers, the timing versus robust issuance may provide an opportunity to purchase bonds that recently entered the secondary market at attractive levels. Temporary periods of outsized issuance could also challenge the primary market. Depending on timing and magnitude of the calendar, upcoming new issues could represent value not seen in months.

Individual investors should be paying close attention and remain engaged. Also consider defensively upgrading portfolios by selling weaker credits and low-coupon structures, as the strong bond market, along with equity market gains, can mitigate and offset losses, respectively.

Morgan Stanley says the muni-bond market often slows down considerably during the final two weeks of the year in terms of both supply and demand, and after a strong 2014 so far, “many market participants may want to close the books early and wish away the final weeks in order to lock in what was largely an unexpectedly strong performance.” Meanwhile, as rates have fallen this year, municipal bond issuers are increasingly issuing new bonds to refund old ones. More from MS:

[W]e do expect moderate-to-robust issuance to continue into mid-December (except for Thanksgiving week)…and then pick up again in mid-January, as additional refunding candidates come into play…. Further, the potential for temporary periods of outsized ($8 billion or more) issuance specifically surrounding Thanksgiving week could also create a temporary supply/demand imbalance in the primary market.

In the longer term, MS says it’s still cautious about munis since interest rates are expected to rise next year. MS’s base case targets for the 10-year U.S. Treasury yield now stand at 2.40% for year end 2014, 2.50% at the close of 2Q15, and 2.70% for the end of 3Q15. “If these forecasts come to fruition, the mild and gradual drift higher in yields next year should be healthier for the bond market versus the taper-driven upheaval of 2013,” MS writes.

It’s not exactly a Charlie Gasparino versus Ron Insana Twitter fight, but the two biggest rating agencies are taking pretty different views on the impact of Detroit’s bankruptcy exit plan that a judge just confirmed today. S&P put out a statement saying the plan wouldn’t have any impact on S&P’s ratings of general obligation muni bonds, even though bondholders recovered a lot less money than expected compared to other creditors, particularly public pension recipients. By contrast, Moody’s Investors service just put out a statement saying the ruling “is generally credit negative for municipal investors because it reinforces favorable treatment of pension claims over other unsecured creditors. It also solidifies impairment of general obligation (GO) bonds.”

Moody’s says the plan is bad for GO bond investors in general, and Michigan GO bondholders in particular:

These creditors accepted impairments to their debt. In the absence of clear court opinions on the strength of each pledge, investors will therefore be more likely to negotiate with distressed cities in the future.

And more from Moody’s:

In confirming the plan, the court is sanctioning varying recovery rates amongst Detroit’s unsecured creditors. Reported recoveries for unsecured creditors range from an estimate of 14% for Certificates of Participation (COP) creditors to up to 82% for pension claims in real benefit terms. This disparate treatment of creditors was also a feature of the Stockton bankruptcy. These discrepancies leave investors with more questions than answers, but the emerging picture is one in which pensions have better recovery probabilities than debt in a Chapter 9 case, and municipalities exiting from bankruptcy likely retain responsibility for paying down large unfunded pension liabilities. We also note the confirmation does not affect existing settlements with Detroit creditors. Our ratings already reflect the recovery creditors will receive from those settlements,

It can be tempting for muni investors to load up on home-state bonds to target the tax-free income you get as a resident in most states. But diversification is as important in the muni market as it is to other types of investing. Alan Schankel, municipal bond strategist at Janney Montgomery Scott, says no more than half of a muni portfolio should consist of any single state’s bonds, with the rest consisting of bonds from various other types of issuers and sectors. From Schankel:

An unforeseen event such as a natural disaster can have a negative impact on bond issuers of a particular state or region. A state may enact legislation which alters the tax, regulatory or legal environment to the detriment of bondholders. Nevertheless many investors pursue a single state strategy not only for the tax benefit, but also, we’ve found, because they prefer issuers with whom they are more familiar. There is no investment advantage for a Florida resident to hold all Florida bonds, since there is no state personal income tax, yet we often see all Florida portfolios.

One New York investor responded to our multi-state diversification advice by saying she was diversified because her holdings included not just NY state issues such as general obligations and personal income tax secured bonds, but also a variety of local school districts from across the state. She was surprised when we explained that the school districts to varying degrees relied on state aid payments for much of their revenue stream. The majority of her municipal bonds relied on the revenues of a single state.

A basic Janney model portfolio allocates 20% apiece to state government and local government bonds. Then 15% is allocated to public school districts and another 15% to municipal utility revenue bonds, such as water and sewer bonds. Another 10% goes to transportation revenue bonds, which back things like airports and turnpikes. Of the rest, 8% goes to nonprofit healthcare bonds, 7% to higher-education bonds, and 5% to single-family housing bonds. “This type of diversification not only spreads risk, but can generate higher yields, since sectors peripheral to state and local government often offer slightly better returns than like rated issuers in the core state and local government area,” Schankel writes.

For example a $500,000 10 year ladder might have $50,000 maturing each year from year one out to 10 years. Shorter maturities provide liquidity while longer maturities enhance the portfolio yield. As short bonds mature, the proceeds of a maturing bond purchased a year ago can be redeployed into a new 10 year maturity bond, since last year’s 10 year bond is now a 9 year bond. More conservative investors might limit the maximum maturity by constructing a 5 year ladder, while more aggressive investors can choose to increase income by using a longer ladder structure. Another potential strategy, depending on the investor’s view of future interest rate changes, might be a barbell structure with bonds divided between short maturities (for liquidity) and long maturities (for income).

As expected, a trio of federal regulators today announced a new rule governing what sort of investments banks can count toward their most liquid holdings that can provide them with cash in the event of another crisis, but didn’t really resolve where municipal bonds will end up on the spectrum of so-called high-quality liquid assets.

The Federal Reserve Board, the Federal Deposit Insurance Corporation, and the Office of the Comptroller of the Currency said the rule aim to “strengthen the liquidity positions of large financial institutions.” From their joint announcement:

The rule will for the first time create a standardized minimum liquidity requirement for large and internationally active banking organizations. Each institution will be required to hold high quality, liquid assets (HQLA) such as central bank reserves and government and corporate debt that can be converted easily and quickly into cash in an amount equal to or greater than its projected cash outflows minus its projected cash inflows during a 30-day stress period. The ratio of the firm’s liquid assets to its projected net cash outflow is its “liquidity coverage ratio,” or LCR.

The LCR will apply to all banking organizations with $250 billion or more in total consolidated assets or $10 billion or more in on-balance sheet foreign exposure and to these banking organizations’ subsidiary depository institutions that have assets of $10 billion or more. The rule also will apply a less stringent, modified LCR to bank holding companies and savings and loan holding companies that do not meet these thresholds, but have $50 billion or more in total assets. Bank holding companies and savings and loan holding companies with substantial insurance or commercial operations are not covered by the final rule.

In a separate statement, Fed Governor Daniel Tarullo explained that the status of municipal bonds is still more or less up in the air:

The proposed rulemaking excluded state and municipal bonds from the various categories of high-quality liquid assets (HQLA) that make up the numerator of a bank’s liquidity coverage ratio. While it is true that most state and municipal bonds are not sufficiently liquid to serve the purposes of HQLA in stressed periods, public comments and staff analysis over the past several months suggest that the liquidity of some state and municipal bonds is comparable to that of the very liquid corporate bonds that can qualify as HQLA. Staff has been working on ideas to develop some criteria for determining which such bonds fall into this category and thus might be considered for inclusion as HQLA. That work has not yet been completed, and it is important to get this final rule adopted now, so that the largest banks can begin to prepare for its implementation on January 1. However, I anticipate that staff will be coming back to us with a report on efforts to develop a proposal along these lines.

With the Fed poised to start hiking short-term rates in the next year or so, BlackRock sees interest rates becoming more volatile and says municipal bond investors should be looking to the same unconstrained-style fund strategies that have been gobbling up market share across the broader bond market. Peter Hayes, head of BlackRock’s muni bond group, says investors should be thankful for the big gains posted by munis so far this year, up 6% through July, but that “caution is warranted” at this point and investors should “protect those gains rather than reach for more.”

It’s a concept that’s just taking hold in the muni space, and we think it makes a lot of sense. Essentially, an unconstrained municipal strategy, such as our own Strategic Municipal Opportunities Fund (MAMTX), is a flexible, one-stop solution that invests across the entire municipal spectrum. It’s not limited to bonds of a particular credit quality or maturity date. Importantly, we are able to manage interest rate risk by adjusting our duration as needed in an effort to mitigate the losses that accompany a rise in interest rates. It’s a kind of flexibility not previously available, and we think it can add a lot of diversification to your muni allocation at a time when market uncertainty demands a high level of adaptability.

Fund management firms have been pitching unconstrained strategies as solutions to bond investing at a time when rates are expected to rise, and unconstrained funds have surged in popularity in the wake of the spike in bond yields during May and June 2013. As I wrote in my Barron’scover story last October, these funds can make sense as complementary holdings to traditional bond funds, but investors need to keep an eye on what these funds hold, since they can move in and out of investments quickly and frequently, and one firm’s unconstrained strategy can bear little resemblance to another’s. BlackRock’s flexible muni fund is up 7.56% so far this year.

Amey Stone is Barron’s Income Investing blogger and Current Yield columnist. She was formerly a managing editor at CBS MoneyWatch, MSN Money and AOL DailyFinance. Her responsibilities included overseeing market coverage and personal finance topics. Prior to those roles, she was a senior writer at BusinessWeek where she authored the Street Wise column online and contributed to the magazine’s Inside Wall Street column. Topics covered included economics, corporate finance, Fed policy, municipal bonds, mutual funds and dividend investing. She co-authored King of Capital, a biography of Citigroup Chairman Sandy Weill. She is a graduate of Yale University and Columbia University’s Graduate School of Journalism.